What’s valuation – why are we as an ecosystem this preoccupied with the valuation of a startup? Which startup has become a ‘unicorn’, which one’s a ‘soonicorn’– even startup news cycles are dominated by the valuation discussion when a startup raises funds. We are all drawn by the big numbers, so this obsession is not surprising. But as investors, is valuation the only parameter you should consider when investing in a startup, especially at the growth stage? Particularly, in a situation where you are not the lead or the anchor investor. In such situations, you might not have a big say on what the valuation of a startup is. The question you have to then answer is, ‘Why should I invest in this startup at this valuation?’
Put away the early stage startup hat…
I have seen investors sometimes make the error of looking at a growth stage startup from an early-stage investor’s lens or vice versa. This is wrong.
When a startup is in its early days, the idea is raw and untested and that is what the investor is backing–it is a leap of faith. Maybe there is a Minimum Viable Product (MVP), but it is unlikely that product-market-fit has been achieved. In such a scenario, an investor should assess the company based on the following:
- The problem the startup is attempting to solve
- The quality or capability of founders, as the team is most important at this stage
- How the startup and team is attempting to solve the problem
- The market opportunity and the startup’s potential for scale
Importantly, at the early-stage, there are no real numbers or metrics available, beyond potential market size and past track record of the founders with a future lens of vision. The assessment is future-focused
…and wear the growth stage startup hat
When a startup is out for growth funding, the company has achieved product-market fit, has stepped on the scale ladder, and has built up a market, even if small, for itself. Further, a number of business performance numbers and metrics are available that offer a chance at a more objective appraisal of a startup.
The Growth Stage Investment Checklist
While the market might still be relatively small, the stickiness of the customers or how often does the same customer comes back for more without the startup spending more money is a good way to gauge the quality of the product. Repeat User Rate, Customer Acquisition Cost and similar metrics are good assessment tools to understand this. The overall size of the target market also becomes important.
I have seen investors shy away from investing in startups that have a Goliath of a competitor in the same or allied space. However, in today’s tech era many large tech or tech-enabled conglomerates can set their sight on a new and potentially lucrative sector at any time. So, if you start shying away from companies because of fear of the giant competitor, you might end up not making meaningful investments. In fact, a large competitor is also a validation of the potential a sector has. However, it is important to ascertain that the startup has clear differentiation and is not just a me-too. It is a differentiation that will ensure that a startup stays ahead. TikTok succeeded despite the presence of a Facebook. Many ecommerce startups, like Nykaa, are doing well despite the presence of Amazon and Flipkart. There are many such examples and you will find they all possess ‘differentiated offering’.
Linked to differentiation, the moat is the competitive advantage a business has built that makes it difficult for a competitor to catch up or unseat them. This could include product, technology, team, process innovations or even brand and brand recall. For example, Prime is a great moat for Amazon. In the case of BigBasket, where technology innovation does not really come into play, it is the process innovation that it has done from supply chain to delivery that has been hard to replicate for competitors. In its business of offering convenience to consumers, reliable service is its moat.
While in the early stage the quality of founders is paramount, by the growth-stage the expectation is that a leadership team and a full-fledged organization have been built. The larger team has to now execute on a bigger plan. Their quality matters. Equally important are issues like governance, compliance, and the company board.
While linked to market size and customer growth and retention, a startup’s ability to scale needs a deeper dive into how it does business. Is the company obsessed with growth? A growth stage startup should be achieving or aiming for exponential growth. Have economies of scale been triggered or have they been identified? Closely linked to this, is the hunger the founder has. The founder is already battle-scarred by this stage; does he have the stomach for more? Is he thriving under the circumstances, does he have the fire in his belly for exponential value creation, or is looking for a quick and easy exit soon?
Burn & Path to Profit
Linked to scale is the burn rate. This is a double-edged sword. Say a startup has scaled and has a good customer base, unit economics is good and the growth rate is consistent though low and the company is not ‘burning’ money in the chase for growth. This might show that the company has good fundamentals, but what is the investor’s role here? Will the company raise more capital down the road? If the company does not need to raise capital, what is the exit option available to the investor? Also, tomorrow a competitor might arrive, spending big bucks and capturing the market if differentiation is not that clear. Thin lines divide low burn, the right burn, and too much burn and as an investor, you need to watch this closely. On the other hand, a startup may be spending heavily to capture the market, but it should be able to show the ability to continue to grow even at lower spending or illustrate the timeline for network effects to kick in. Further, while most growth-stage startups are loss-making and spending heavily, they should have a path to profitably planned and charted out.
The track record and performance of existing investors, the lead investor in the current round, and fellow investors are also important. This is not just in terms of how well their investments have done but also in how well they have supported their investee ventures. Investment horizons are typically five years and above and these fellow travelers can greatly influence business outcomes. In some cases, a strategic co-investor could offer an exit opportunity a few years later.
The hope all investors have is to find that startup that can be valued based on traditional earnings multiple formulae. But, in the present Indian ecosystem, such a startup is truly a mythical beast. We see in developed markets like the US, companies like Tesla and Uber getting valued in the billions—Tesla is valued at about $400 billion, while Uber’s valuation is at about $60 billion—-for their execution and business model. Uber continues to make losses, while Tesla has been able to show profits only because of the income from the sale of its regulatory credits; Tesla’s core business of electric vehicle manufacturing and sales is loss-making. Current profitability is not that important a concern, as the future looks bright.
Why can’t startups be like public companies?
This is a lament I have heard from investors who have traditionally invested in the public market. It can do you only harm if you compare startups to publicly listed companies. In the public market, the companies are established and profitable ventures with steady growth and detailed and transparent reporting and analysis help investors better manage risks, hedge bets, and realign allocation. Startups are high growth companies, with high cash burn rates and losses. They are most likely working on new technology offerings or disrupting existing industries or carving out new niches. Obviously then the risk is high. However, only startups have the potential to create exponential value and offer non-linear growth. I will write a specific piece on public markets versus private markets in the near future to elaborate further.
Globally, the private market has outperformed the public market, with global PE net asset value has multiplied eight times since 2000. This is about three times faster than public market capitalization, which has grown approximately 2.8 times over the same period, according to McKinsey & Company’s Global Private Markets Review 2020.
For investors looking to diversify from public to private market, investing in a growth stage startup is an easier bridge to cross than early-stage investments. Like I said, growth-stage companies have performance metrics that investors can assess. Thus, compared to early-stage investing, in the growth-stage, there is ‘medium’ risk and still potential for high returns.
The Exit Challenge
While exit opportunities continue to worry many investors in India, the market is definitely maturing and acquisitions like the $300-million Byju’s-WhiteHat Jr deal definitely boost confidence. A report by EY and Indian Private Equity and Venture Capital Association shows that the total value of PE and VC exits stood at $11.1 billion in 2019. However, private equity and venture capital investments are still relatively illiquid and the holding period can be quite long, going beyond even five years. This is why in more developed markets like the US, the private equity secondary market has come up and is maturing. With the Indian startup ecosystem becoming more stable and mature, there is great potential for a private equity marketplace in India. We at LetsVenture Plus offer a transparent private equity marketplace, ensuring investors are informed and a growth stage startup has wider access to investor money from UHNIs and Family Offices, serving a dual purpose of increased domestic capital participation and, at the same time, providing exits to early investors and ESOP holders. As the Indian startup ecosystem grows from strength to strength, I envision bringing more such product offerings that enable greater liquidity and exit options to investors and be a true blood marketplace.
Those looking to back growth-stage startups should not make investment decisions purely based on excel sheets and charts. The metrics definitely help, but understanding what makes a company truly tick is what will set apart a winning investment from the rest. And as I say, focus on the three Es – Execution, Execution, Execution.
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